LONDON — Last week, Berkshire Hathaway Inc. (NYSE:BRK.B) boss Warren Buffett released his annual letter to shareholders.
If you’re a U.K. investor just starting out, U.S. investing legend Buffett may be new to you — perhaps your interest in the man has been piqued by reading about how he’s taken a big stake in Tesco PLC (LON:TSCO).I can tell you that Buffett’s annual letters never fail to educate, amuse, and enrich. You’ll find abundant pearls of wisdom in his witty, colourful, and incisive commentaries — as, indeed, will old hands.
586,817% and counting
Let’s start with why Buffett has captured the attention of millions of investors around the world. The bottom line is, his Berkshire Hathaway group has an outstanding record of increasing shareholder value over the best part of five decades.
Between 1965 and 2012, Berkshire’s book value per share has increased by a mind-boggling 586,817%, representing a compound annual growth rate of close to 20%. Such gains over such a long period are unparalleled.
Buffett’s strategy of wealth creation for Berkshire is something ordinary investors like us can learn from in weighing up companies we may want to invest in.
Successful businesses generate cash. Buffett is clear about what a company should do with that cash, in the following order of priority:
First, examine reinvestment possibilities offered by its current business for increasing the competitive advantage over rivals.
Second, look at acquisitions that are likely to make shareholders wealthier on a per-share basis than they were prior to the acquisition.
Third, consider repurchasing the company’s own shares to enhance each investor’s share of future earnings.
Fourth, by default, pay dividends to shareholders.
Reinvestment and acquisitions
By reinvestment in the business, Buffett is referring to spending on projects “to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.”
When we, ourselves, are considering companies to invest in, we can check how intelligently management is reinvesting in the business by looking at such things as whether market share is being maintained/increased, and whether margins are being maintained/grown relative to rivals.
Buffett considers small bolt-on acquisitions that can easily be integrated into existing operations as part of the reinvestment in the business. The acquisitions referred to in stage two of his four steps are those that add something new to the company — some form of diversification.